Reverse LKE Programs
Rev. Proc. 2003-39 offers additional safe harbors to Exchangors engaged in frequent personal property exchanges. Programs based on this Rev. Proc. have been executed for years on behalf of Exchangors in the automobile and trucking industries, for example, as well as leasing companies and other concerns where similar assets are frequently bought and sold. The primary benefit of programs of this type, when executed in a delayed exchange mode, is the availability of substantial additional capital resulting from the ongoing deferment of taxes on gains resulting from recapture of depreciation. While many of the very-high-volume programs are designed to be "cash-less" relative to the QI involved in the delayed exchanges, many low- and medium-volume programs do have cash proceeds from Old Asset dispositions being held by the QI.
ExStra has developed processes for LKE programs using either of the basic reverse forms — Exchange Last (with or without improvements) or Exchange First. Our LKE programs involving parking assets, as opposed to parking cash, while Old Assets are sold. The additional benefits that may accrue are:
- Timing and Asset Management. Since each individual exchange is triggered by an acquisition, meeting the 45-day identification requirements is accomplished using like-kind assets already owned, increasing the likelihood of a successful exchange. Furthermore, exchange activity can be driven by business requirements and events, rather than having the identification and acquisition of New Assets being artificially driven by 1031 exchange deadlines
- Return on Capital. In a reverse LKE program, New Assets can be acquired when needed to satisfy new business opportunities, replace aging equipment or for deployment in a project. Similarly, Old Assets can be productively deployed for an optimal time period. Assets managed in these ways typically provide significantly more Return on Capital ("ROC") to the Exchangor than if the cash proceeds of Old Asset dispositions are placed in the hands of a QI as part of a delayed LKE program.
- Asset Security. Unfortunately, the QI industry has been rocked by numerous failures in the last 2-3 years. Some of the failures have been due to theft or fraud, some due to unwise investment decisions and some due to business failure of the QI. In all these cases, the cash held by the QI on behalf of its clients has been completely or partially lost, causing enormous problems for the Exchangors. By contrast, reverse LKE programs seldom, if ever, result in any cash being held by the QI and never in the accumulation of large (and tempting) cash balances. Assets are parked in bankruptcy-remote LLCs that are specifically formed with the Exchangor’s requirements (locality, potential for assignment, securitization) reflected in the operating agreement and attending documentation. Besides, what would ExStra do with a piece of heavy equipment, for example, that its Client was using on a project? A trite question, perhaps, but it reflects the genuine realty of the differences between delayed and reverse programs regarding asset security.
Reverse LKE Processes
A brief description of the Exchange Last form of a reverse LKE program follows. The Exchange First version of this process is similar except that Old Assets are parked in EATs. The decision to use Exchange First or Exchange Last forms will likely be related to the means used to finance New Asset acquisitions, with Exchange First being preferable if there are complications with 3rd-party lenders providing all or part of the New Asset purchase money.
The EAT structure we use allows for both separation of assets and the ability to respond very quickly to a decision to purchase New Assets. In some situations, we will form a single LLC in the desired jurisdiction and use it for all transactions. In other, we may employ a Delaware series LLC (the "Master EAT") that permits individual EATs (series LLCs) to be formed in response to specific New Asset acquisitions. The Delaware structure allows individual series LLCs to be formed without specifically communicating with the Delaware authorities, resulting in the ability to form EATs (literally) in a matter of minutes. Similarly, EATs can be dissolved with the same ease and timing. We will also secure a resale license for the (Master) EAT in the appropriate jurisdiction, so that it will be exempt from local sales and use taxes to the greatest extent possible.
Reverse LKE Documentation (Exchange Last)
The goal of the various documents is to be in compliance with all of the relevant provisions of both Rev. Proc. 2000-37 and Rev. Proc. 2003-39 while achieving strict adherence to the requirements of IRC §1031. Accordingly, the structure requires:
- A Master Qualified Exchange Accommodation Agreement which describes the mechanism for each separate reverse exchange
- A Master Exchangor Note, which will allow the funds required to buy the various New Assets to be borrowed interest-free from the Exchangor
- A Master Lease, by which the relevant EAT will lease the New Assets to the Exchangor on a rent-free, triple-net basis
- A Master Exchange Agreement by which each reverse exchange will be completed when the designated Old Assets have been sold through a simultaneous §1031 exchange
Acquisition & Disposition Mechanics
Once all the master agreements are in place, the mechanism for the individual exchanges is as follows:
- When a New Asset purchase is imminent, a new EAT will be formed for the particular reverse exchange involving the New Asset
- The Exchangor must provide to the Seller of the New Assets a formal "Notice to the Seller" informing them that the New Assets will be involved in a 1031 exchange. The form of the notice is provided by ExStra but must be issued on the Exchangor’s letterhead. As structured, the notice is required once per unique Seller and not for each individual New Asset purchase
- The EAT will acquire the New Asset from the relevant Seller using funds supplied by the Exchangor pursuant to the Master Exchangor Note. Title will transfer to the EAT using a standard documentation form (probably a Bill of Sale) made in favor of the EAT.
- The Exchangor will be required to execute simple addenda to the various Master agreements that 1) initiate the specific reverse exchange involving the New Assets, 2) add the New Assets to the Master Lease and 3) draw the additional funds required to buy the New Assets pursuant to the Master Note. The forms for these addenda are determined at the outset of the exchange program and no review or modification of them, other than providing the specifics of the New Assets, should be required.
- The Exchangor will then have 45 days to identify potential Old Assets that may be sold as part of the exchange. The standard 3-property and 200% identification rules apply in these cases. ExStra provides a form that may be used for the identification.
- Once an agreement with a Buyer for the purchase of Old Assets has been reached, the Exchangor must provide them with "Notice to the Buyer". This is a notice to each Buyer that Old Assets will be involved in a 1031 exchange. The form of the notice is provided but must be issued on the Exchangor’s letterhead. As structured, the notice is required once per unique Buyer and not for each individual asset sale.
- Once the sale of properly identified Old Assets is about to be consummated, an addendum to the Master Exchange Agreement will be executed along with a brief Settlement Statement describing the movement of consideration and the transfer of assets to the Old Asset Buyer and to the Exchangor (the New Assets) pursuant to a simultaneous 1031 exchange. A Bill of Sale in favor of the Exchangor for the New Assets will be issued at that time.